How much stock do you need to carry on hand? The simple answer is enough to keep up with consumer demand. Randomly filling a warehouse with products might help you keep up with demand, but it could eat up capital and warehousing space.
Suppliers can be unreliable, so you have to account for that as well. At times, demand can suddenly increase for unknown reasons, so you have to plan for that contingency. How do you account for all these variables and keep just enough inventory on hand?
You can accomplish this by setting a reorder point — a quantity that triggers the purchase of a specific stock item. You can find that value by using a reorder point formula. This formula will take the variables we just discussed and give you the answer. But this will not be a static number that you set and forget. It will be based on your purchase and sales cycles and will change over time.
How to Calculate a Reorder Point
We will start by studying these variables and see how to put them together to find a reorder point. We will use a fictional company called Vagabond Electronics and calculate the reorder point of their new smart light bulbs.
Average Daily Sales Units
The first number you need is the average daily units you’ve sold of a product. Vagabond has only been in business three months and sold 60 light bulbs in January, 90 in February, and 120 in March for a total of 270 lightbulbs sold in 90 days. The average daily sales for this light bulb is three per day.
This is just the average daily sales for the light bulbs. Each product will be unique. Some items will be more popular than others and will have to be ordered in more volume and frequency. Some items will sell quicker during certain seasons like Christmas, which is another reason why average daily sales have to be recalculated frequently.
Average Delivery Lead Time
Average delivery lead time is the time it takes from ordering a product to having it on your shelves and ready to ship. If you deal with more than one supplier, each will have a different lead-time. Products that need to ship from overseas will take longer to get to your warehouse, which means you will have to reorder more at a time to keep stock at the levels you need. But a supplier that ships express from the same state will allow you to have less in stock because it only takes a few days to replenish your inventory.
Vagabond Electronics has placed three orders for light bulbs in the three months that they have been open. The first order took only four days, the second took five days, and the third took six days. To get our average lead time, you just need to add the days together which gives us 15 and then divide by three. This makes the average delivery lead time five days.
Safety stock is stock you keep on hand “just in case” something goes wrong and demand outpaces supply. For example, a product goes viral and suddenly you are selling it faster than you can keep it on the shelves, which is great news for your business until you run out of stock and have to deal with backorders and irate customers. Or maybe your supplier’s factory burned to the ground. You can never know exactly what you will have to face in the future of your business, but you can plan for unforeseen events.
You do this with safety stock. You can calculate safety stock in a few different ways. A common formula is:
(maximum daily sales x maximum lead time) – (average daily sales x average lead time)
You will subtract the average scenario from the worst-case scenario, at least when it comes to keeping products on the shelf. You already have three of the numbers we need to apply this formula to get the safety stock value for Vagabond Electronics’ light bulbs. The last number we need is maximum daily sales, which happened in March after they sent out a coupon to past buyers. On that day, they sold eight light bulbs. Now, plug the numbers into the formula and you get:
(8 x 6) – (3 x 5) = 33
So Vagabond Electronics needs 33 light bulbs as safety stock.
Safety stock is also a number that will have to be recalculated with seasonal sales. For example, if the product you are setting safety stock levels for are school lunchboxes, you will want to set your safety stock level based on last year’s school season right before this year’s season starts and then adjust the number back down as sales drop off before summer.
Putting a Reorder Point Formula to Use
Now that you have figured out all the variables you need, plug them into a reorder point formula, and find the reorder point for Vagabond light bulbs. This formula is simple:
(average daily sales units x average delivery lead time) + safety stock = reorder point
So for the light bulbs, we get:
(3 x 5) + 33 = 48
So whenever Vagabond’s stock of light bulbs drops to 48, they need to reorder more. When sales are regular, Vagabond would never have to touch their safety stock. But if a perfect storm hits and they sell the maximum amount they have ever sold for days in a row and their supplier lead time increases, they will have the safety stock they need to cover it.
Using Reorder Point Calculators
Setting reorder points is a critical part of managing your inventory. They help you keep your business running smoothly by ensuring you always have stock on hand for any orders you may have. But reorder points will only work for you if they are accurate, they are recalculated when your sales cycles change, and you are alerted when your stock levels drop to the reorder point.
You can use a spreadsheet to hold your inventory and an online reorder point calculator to set the reorder points, but you may have problems with accuracy and end up with a lot of manual work to do. There are a few ways to calculate safety stock, some more accurate than others depending on your sales cycles. We used a simple version to calculate the safety stock for Vagabond’s light bulbs. Whenever a business moves out of the startup phase, it is time to look at an automated inventory management system to make this process easier and trouble-free. The right inventory management system will not only keep track of your inventory and create a purchase order for you when something needs to be reordered but will also be able to use a more complex and accurate formula to calculate reorder points that will change to keep up with changes in your business.